Fifth Third Bancorp. CEO KEVIN T. KABAT bought 10000 shares on 2-27-2008 at 25.05
MANAGEMENT DISCUSSION FOR LATEST QUARTER
This overview of managementâ€™s discussion and analysis highlights selected information in the financial results of the Bancorp and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting policies and estimates, you should carefully read this entire document. Each of these items could have an impact on the Bancorpâ€™s financial condition and results of operations.
The Bancorp is a diversified financial services company headquartered in Cincinnati, Ohio. At September 30, 2007, the Bancorp had $104.3 billion in assets, operated 18 affiliates with 1,181 full-service Banking Centers including 104 Bank Mart Â® locations open seven days a week inside select grocery stores and 2,153 Jeanie Â® ATMs in Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia, Pennsylvania and Missouri. The Bancorp reports on five business segments: Commercial Banking, Branch Banking, Consumer Lending, Investment Advisors and Fifth Third Processing Solutions (â€śFTPSâ€ť).
The Bancorp believes that banking is first and foremost a relationship business where the strength of the competition and challenges for growth can vary in every market. Its affiliate operating model provides a competitive advantage by keeping the decisions close to the customer and by emphasizing individual relationships. Through its affiliate operating model, individual managers from the banking center to the executive level are given the opportunity to tailor financial solutions for their customers.
The Bancorpâ€™s revenues are fairly evenly dependent on net interest income and noninterest income. For the three months ended September 30, 2007, net interest income, on a fully taxable equivalent (â€śFTEâ€ť) basis, and noninterest income provided 51% and 49% of total revenue, respectively. Therefore, changes in interest rates, credit quality, economic trends and the capital markets are primary factors that drive the performance of the Bancorp. As discussed later in the Risk Management section, risk identification, measurement, monitoring, control and reporting are important to the management of risk and to the financial performance and capital strength of the Bancorp.
Net interest income is the difference between interest income earned on assets such as loans, leases and securities, and interest expense paid on liabilities such as deposits and borrowings. Net interest income is affected by the general level of interest rates, the relative level of short-term and long-term interest rates, changes in interest rates and changes in the amount and composition of interest-earning assets and interest-bearing liabilities. Generally, the rates of interest the Bancorp earns on its assets and owes on its liabilities are established for a period of time. The change in market interest rates over time exposes the Bancorp to interest rate risk through potential adverse changes to net interest income and financial position. The Bancorp manages this risk by continually analyzing and adjusting the composition of its assets and liabilities based on their payment streams and interest rates, the timing of their maturities and their sensitivity to changes in market interest rates. Additionally, in the ordinary course of business, the Bancorp enters into certain derivative transactions as part of its overall strategy to manage its interest rate and prepayment risks. The Bancorp is also exposed to the risk of losses on its loan and lease portfolio as a result of changing expected cash flows caused by loan defaults and inadequate collateral, among other factors.
Net interest income, net interest margin, net interest rate spread and the efficiency ratio are presented in Managementâ€™s Discussion and Analysis of Financial Condition and Results of Operations on an FTE basis. The FTE basis adjusts for the tax-favored status of income from certain loans and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts.
Noninterest income is derived primarily from electronic funds transfer and merchant transaction processing fees, card interchange, fiduciary and investment management fees, corporate banking revenue, service charges on deposits and mortgage banking revenue.
In May 2007, the Bancorp announced an agreement to acquire R-G Crown Bank (â€śCrownâ€ť), a subsidiary of R&G Financial Corporation, which operates 30 branches in Florida and three in Augusta, Georgia. The Crown acquisition closed in the fourth quarter. In August 2007, the Bancorp announced an agreement with First Charter Corporation to acquire First Charter Bank, a regional financial services company with assets of $4.9 billion and operates 57 branches in North Carolina and two in suburban Atlanta. The First Charter acquisition is subject to legal, regulatory and First Charterâ€™s shareholders approvals and is expected to close in the first quarter of 2008. In September 2007, the Bancorp agreed to purchase nine full service bank branches in Atlanta, Georgia from First Horizon National Corporation. This transaction is expected to close in the first quarter of 2008.
The Bancorpâ€™s net income was $325 million, or $.61 per diluted share, in the third quarter of 2007, compared to $377 million, or $.68 per diluted share, for the same period last year. The Bancorpâ€™s net income reflects a $78 million pretax expense resulting from the Visa/American Express anti-trust litigation settlement announced by Visa on November 7, 2007. For more information see Note 19 of the Notes to Condensed Consolidated Financial Statements.
Net interest income (FTE) increased six percent compared to the same period last year. Net interest margin was 3.34% in the third quarter of 2007, a decrease from 3.37% in the second quarter of 2007 and an increase from 2.99% in the same period last year. The increase from the third quarter of 2006 was largely due to the balance sheet actions taken in the fourth quarter of 2006 to improve the asset/liability profile of the Bancorp, while the sequential decrease was primarily a result of share repurchase activity during 2007 and corresponding reduction in free funding.
Noninterest income increased nine percent and seven percent for the three and nine months ended September 30, 2007, respectively, with strong growth in nearly all captions. Noninterest expense increased 16% and ten percent for the three and nine months ended September 30, 2007, respectively, due primarily to expense associated with the Visa/American Express anti-trust litigation settlement, higher volume-related processing expenses, de novo branch related expenses and investment in technology.
Net charge-offs as a percent of average loans and leases were .60% in the third quarter of 2007 compared to .55% in the second quarter of 2007 and .43% in the third quarter of 2006. The increased charge-offs were primarily driven by losses in the auto and home equity portfolios. At September 30, 2007, nonperforming assets as a percent of loans and leases increased to .92% from .70% at June 30, 2007 and .56% at September 30, 2006. The increase in nonperforming assets was primarily concentrated in the Michigan and Florida real estate markets.
The Bancorpâ€™s capital ratios exceed the â€śwell-capitalizedâ€ť guidelines as defined by the Board of Governors of the Federal Reserve System (â€śFRBâ€ť). As of September 30, 2007, the Tier I capital ratio was 8.46%, the Tier I leverage ratio was 9.23% and the total risk-based capital ratio was 10.87%. The Bancorp had senior debt ratings of â€śAa3â€ť with Moodyâ€™s and â€śA+â€ť with Standard & Poorâ€™s at September 30, 2007, which indicate the Bancorpâ€™s strong capacity to meet its financial commitments. The â€śwell-capitalizedâ€ť capital ratios, along with strong credit ratings, provide the Bancorp with access to the capital markets.
The Bancorp continues to invest in the geographic areas that offer the best growth prospects through acquisitions and de novo expansion. During the third quarter of 2007, the Bancorp opened 14 additional banking centers.
RECENT ACCOUNTING STANDARDS
Note 2 of the Notes to Condensed Consolidated Financial Statements provides a complete discussion of the new accounting standards adopted by the Bancorp during 2007 and 2006 and the expected impact of accounting standards issued but not yet required to be adopted.
CRITICAL ACCOUNTING POLICIES
Allowance for Loan and Lease Losses
The Bancorp maintains an allowance to absorb probable loan and lease losses inherent in the portfolio. The allowance is maintained at a level the Bancorp considers to be adequate and is based on ongoing quarterly assessments and evaluations of the collectibility and historical loss experience of loans and leases. Credit losses are charged and recoveries are credited to the allowance. Provisions for loan and lease losses are based on the Bancorpâ€™s review of the historical credit loss experience and such factors that, in managementâ€™s judgment, deserve consideration under existing economic conditions in estimating probable credit losses. In determining the appropriate level of the allowance, the Bancorp estimates losses using a range derived from â€śbaseâ€ť and â€śconservativeâ€ť estimates. The Bancorpâ€™s strategy for credit risk management includes a combination of conservative exposure limits significantly below legal lending limits and conservative underwriting, documentation and collections standards. The strategy also emphasizes diversification on a geographic, industry and customer level, regular credit examinations and quarterly management reviews of large credit exposures and loans experiencing deterioration of credit quality.
Larger commercial loans that exhibit probable or observed credit weakness are subject to individual review. When individual loans are impaired, allowances are allocated based on managementâ€™s estimate of the borrowerâ€™s ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to the Bancorp. The review of individual loans includes those loans that are impaired as provided in SFAS No. 114, â€śAccounting by Creditors for Impairment of a Loan.â€ť Any allowances for impaired loans are measured based on the present value of expected future cash flows discounted at the loanâ€™s effective interest rate or the fair value of the underlying collateral. The Bancorp evaluates the collectibility of both principal and interest when assessing the need for a loss accrual. Historical loss rates are applied to commercial loans which are not impaired and thus not subject to specific allowance allocations. The loss rates are derived from a migration analysis which tracks the historical net charge-off experience sustained on loans according to their internal risk grade. The risk grading system currently utilized for allowance analysis purposes encompasses ten categories.
Homogenous loans and leases, such as consumer installment, residential mortgage and automobile leases, are not individually risk graded. Rather, standard credit scoring systems and delinquency monitoring are used to assess credit risks. Allowances are established for each pool of loans based on the expected net charge-offs for one year. Loss rates are based on the average net charge-off history by loan category. Historical loss rates for commercial and consumer loans may be adjusted for significant factors that, in managementâ€™s judgment, reflect the impact of any current conditions on loss recognition. Factors that management considers in the analysis include the effects of the national and local economies; trends in the nature and volume of delinquencies, charge-offs and nonaccrual loans; changes in mix; credit score migration comparisons; asset quality trends; risk management and loan administration; changes in the internal lending policies and credit standards; collection practices; and examination results from bank regulatory agencies and the Bancorpâ€™s internal credit examiners.
The Bancorpâ€™s current methodology for determining the allowance for loan and lease losses is based on historical loss rates, current credit grades, specific allocation on impaired commercial credits and other qualitative adjustments. Allowances on individual loans and historical loss rates are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience. An unallocated allowance is maintained to recognize the imprecision in estimating and measuring loss when evaluating allowances for individual loans or pools of loans.
Loans acquired by the Bancorp through a purchase business combination are evaluated for possible credit impairment. Reduction to the carrying value of the acquired loans as a result of credit impairment is recorded as an adjustment to goodwill. The Bancorp does not carry over the acquired companyâ€™s allowance for loan and lease losses nor does the Bancorp add to its existing allowance for the acquired loans as part of purchase accounting.
The Bancorpâ€™s determination of the allowance for commercial loans is sensitive to the risk grade it assigns to these loans. In the event that 10% of commercial loans in each risk category would experience a downgrade of one risk category, the allowance for commercial loans would increase by approximately $59 million at September 30, 2007. The Bancorpâ€™s determination of the allowance for residential and consumer loans is sensitive to changes in estimated loss rates. In the event that estimated loss rates would increase by 10%, the allowance for residential and retail loans would increase by approximately $28 million at September 30, 2007. As several quantitative and qualitative factors are considered in determining the allowance for loan and lease losses, these sensitivity analyses do not necessarily reflect the nature and extent of future changes in the allowance for loan and lease losses. They are intended to provide insights into the impact of adverse changes in risk grades and estimated loss rates and do not imply any expectation of future deterioration in the risk rating or loss rates. Given current processes employed by the Bancorp, management believes the risk grades and estimated loss rates currently assigned are appropriate.
The Bancorpâ€™s primary market areas for lending are Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia, Pennsylvania and Missouri. When evaluating the adequacy of allowances, consideration is given to this regional geographic concentration and the closely associated effect changing economic conditions have on the Bancorpâ€™s customers.
In the current year, the Bancorp has not substantively changed any material aspect of its overall approach to determine its allowance for loan and lease losses. There have been no material changes in assumptions or estimation techniques as compared to prior periods that impacted the determination of the current period allowance for loan and lease losses.
Valuation of Securities
Securities are classified as held-to-maturity, available-for-sale or trading on the date of purchase. Only those securities classified as held-to-maturity are reported at amortized cost. Available-for-sale and trading securities are reported at fair value with unrealized gains and losses included in accumulated other comprehensive income, net of related deferred income taxes, on the Condensed Consolidated Balance Sheets and noninterest income in the Condensed Consolidated Statements of Income, respectively. The fair value of a security is determined based on quoted market prices. If quoted market prices are not available, fair value is determined based on quoted prices of similar instruments. Realized securities gains or losses are reported within noninterest income in the Condensed Consolidated Statements of Income. The cost of securities sold is based on the specific identification method. Available-for-sale and held-to-maturity securities are reviewed quarterly for possible other-than-temporary impairment. The review includes an analysis of the facts and circumstances of each individual investment such as the severity of loss, the length of time the fair value has been below cost, the expectation for that securityâ€™s performance, the creditworthiness of the issuer and the Bancorpâ€™s intent and ability to hold the security to recovery. A decline in value that is considered to be other-than-temporary is recorded as a loss within noninterest income in the Condensed Consolidated Statements of Income. At September 30, 2007, 95% of the unrealized losses in the available-for-sale security portfolio were comprised of securities issued by U.S. Treasury and Government agencies, U.S. Government sponsored agencies and states and political subdivisions as well as agency mortgage-backed securities. The Bancorp believes the price movements in these securities are dependent upon the movement in market interest rates. The Bancorpâ€™s management also maintains the intent and ability to hold securities in an unrealized loss position to the earlier of the recovery of losses or maturity.
Reserve for Unfunded Commitments
The reserve for unfunded commitments is maintained at a level believed by management to be sufficient to absorb estimated probable losses related to unfunded credit facilities. The determination of the adequacy of the reserve is based upon an evaluation of the unfunded credit facilities, including an assessment of historical commitment utilization experience, credit risk grading and credit grade migration. Net adjustments to the reserve for unfunded commitments are included in other noninterest expense.
The Bancorp estimates income tax expense based on amounts expected to be owed to the various tax jurisdictions in which the Bancorp conducts business. On a quarterly basis, management assesses the reasonableness of its effective tax rate based upon its current estimate of the amount and components of net income, tax credits and the applicable statutory tax rates expected for the full year. The estimated income tax expense is recorded in the Condensed Consolidated Statements of Income.
Deferred income tax assets and liabilities are determined using the balance sheet method and are reported in accrued taxes, interest and expenses in the Condensed Consolidated Balance Sheets. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax basis of assets and liabilities and recognizes enacted changes in tax rates and laws. Deferred tax assets are recognized to the extent they exist and are subject to a valuation allowance based on managementâ€™s judgment that realization is more-likely-than-not.
Accrued taxes represent the net estimated amount due to taxing jurisdictions and are reported in accrued taxes, interest and expenses in the Condensed Consolidated Balance Sheets. The Bancorp evaluates and assesses the relative risks and appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other information and maintains tax accruals consistent with its evaluation of these relative risks and merits. Changes to the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations being conducted by taxing authorities and changes to statutory, judicial and regulatory guidance that impact the relative risks of tax positions. These changes, when they occur, can affect deferred taxes and accrued taxes as well as the current periodâ€™s income tax expense and can be significant to the operating results of the Bancorp. As of January 1, 2007, the Bancorp adopted FASB Interpretation No. 48, â€śAccounting for Uncertainty in Income Taxes.â€ť Refer to Note 2 of the Notes to Condensed Consolidated Financial Statements for the impact of adopting this interpretation. As described in greater detail in Note 10 of the Notes to Condensed Consolidated Financial Statements, the Internal Revenue Service is currently challenging the Bancorpâ€™s tax treatment of certain leasing transactions.
Valuation of Servicing Rights
When the Bancorp sells loans through either securitizations or individual loan sales in accordance with its investment policies, it often retains servicing rights. Servicing rights resulting from loan sales are amortized in proportion to and over the period of estimated net servicing revenues. Servicing rights are assessed for impairment monthly, based on fair value, with temporary impairment recognized through a valuation allowance and permanent impairment recognized through a write-off of the servicing asset and related valuation allowance. Key economic assumptions used in measuring any potential impairment of the servicing rights include the prepayment speeds of the underlying loans, the weighted-average life, the discount rate, the weighted-average coupon and the weighted-average default rate, as applicable. The primary risk of material changes to the value of the servicing rights resides in the potential volatility in the economic assumptions used, particularly the prepayment speeds.
The Bancorp monitors risk and adjusts its valuation allowance as necessary to adequately reserve for any probable impairment in the portfolio. For purposes of measuring impairment, the servicing rights are stratified based on the financial asset type and interest rates. In addition, the Bancorp obtains an independent third-party valuation of mortgage servicing rights (â€śMSRâ€ť) on a quarterly basis to assist management in its process. Fees received for servicing loans owned by investors are based on a percentage of the outstanding monthly principal balance of such loans and are included in noninterest income as loan payments are received. Costs of servicing loans are charged to expense as incurred.
The change in the fair value of MSRs at September 30, 2007, due to immediate 10% and 20% adverse changes in the current prepayment assumption would be approximately $26 million and $50 million, respectively, and due to immediate 10% and 20% favorable changes in the current prepayment assumption would be approximately $28 million and $59 million, respectively. The change in the fair value of the MSR portfolio at September 30, 2007, due to immediate 10% and 20% adverse changes in the discount rate assumption would be approximately $25 million and $47 million, respectively, and due to immediate 10% and 20% favorable changes in the discount rate assumption would be approximately $26 million and $55 million, respectively. Sensitivity analysis related to other consumer and commercial servicing rights is not material to the Bancorpâ€™s Condensed Consolidated Financial Statements. These sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10% and 20% variation in assumptions typically cannot be extrapolated because the relationship of the change in assumptions to the change in fair value may not be linear. Also, the effect of variation in a particular assumption on the fair value of the interests that continue to be held by the transferor is calculated without changing any other assumption; in reality, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities. Additionally, the effect of the Bancorpâ€™s non-qualifying hedging strategy, which is maintained to lessen the impact of changes in value of the MSR portfolio, is excluded from the above analysis.
STATEMENTS OF INCOME ANALYSIS
Net Interest Income
Net interest income is the interest earned on debt securities, loans and leases and other interest-earning assets less the interest paid for core deposits (which includes transaction deposits plus foreign office and other time deposits) and wholesale funding (which includes certificates $100,000 and over, other foreign office deposits, federal funds purchased, short-term borrowings and long-term debt). The net interest margin is calculated by dividing net interest income by average interest-earning assets. Net interest spread is the difference between the average rate earned on interest-earning assets and the average rate paid on interest-bearing liabilities. Net interest margin is greater than net interest rate spread due to the interest income earned on those assets that are funded by non-interest bearing liabilities, or free funding, such as demand deposits or shareholdersâ€™ equity.
Net interest income was $760 million for the third quarter of 2007, an increase of $15 million from the second quarter and $41 million from the third quarter of 2006. The improved performance from the same quarter last year resulted from the balance sheet actions in the fourth quarter of 2006, which included, among other actions, the sale of $11.3 billion of available-for-sale securities with a weighted-average yield of approximately 4.30% and repayment of $8.5 billion in wholesale borrowings at a weighted-average rate paid of 5.30%. Net interest income increased $15 million sequentially due to increases in commercial loan volumes, a benefit of $6 million in dividend rate adjustments associated with the agreement to repurchase all issued and outstanding shares of Fifth Thirdâ€™s REIT Series B Preferred Stock, modest decreases in consumer deposit rates and an additional day in the quarter.
Net interest margin decreased to 3.34% in the third quarter compared to 3.37% in the second quarter of 2007. The decline in net interest margin was primarily due to the Bancorpâ€™s net free funding position, calculated as total noninterest-bearing liabilities and shareholdersâ€™ equity less noninterest-earning assets, declining $721 million, or five percent, to $14.3 billion due to share repurchase activity of $693 million and $110 million in the second and third quarters of 2007, respectively. The third quarter net interest margin increased 35 basis points (â€śbpâ€ť) from 2.99% in the third quarter of the prior year, and net interest spread increased 44 bp on a year-over-year basis. The improvement in the net interest margin and net interest spread from the prior year is attributable to the balance sheet actions taken in the fourth quarter of 2006.
Total average interest-earning assets increased seven percent on an annualized sequential basis and declined five percent from the third quarter of 2006. The increase compared to the second quarter was the result of growth in other short-term investments and credit card balances. Other short-term investments grew $286 million to $459 million in the third quarter of 2007 from the second quarter of 2007 due to larger reverse repurchase agreements. Average credit card balances grew nine percent compared to the second quarter as the Bancorp increased its focus on growing its credit card business within its deposit customer base. The decline compared to the prior year is the result of the sales of securities in the fourth quarter of 2006 partially offset by the six percent increase in loan growth.
Interest income (FTE) from loans and leases increased $82 million, or six percent, compared to the third quarter of 2006. The increase resulted from the growth in average loans and leases of six percent in the third quarter of 2007 over the comparable period in 2006 as well as a 3 bp increase in average rates. As of September 30, 2007, approximately 70% of commercial loans will mature or re-price in the next 12 months.
Interest income (FTE) from investment securities and short-term investments decreased $87 million to $156 million in the third quarter of 2007 compared to the same period in 2006. The average yield on taxable securities was 5.00%, an increase of 61 bp from the third quarter of last year. The decrease in interest income and increase in yield resulted from the sale of $11.3 billion of securities with a weighted average yield of 4.30% during the fourth quarter 2006.
Average interest-bearing core deposits increased $1.6 billion or three percent, compared to the third quarter of last year. Beginning in the third quarter of 2007, the Bancorp began reporting commercial customer Eurodollar sweeps in core deposits. The interest rates paid on these accounts are comparable to other commercial deposit accounts. During the third quarter of 2007, the Bancorp continued to adjust its consumer deposit rates. The Bancorpâ€™s strategy in adjusting rates is to move away from promotional rates towards highly competitive daily rates. As a result of this strategy, the Bancorp has continued to be impacted by the migration of interest checking accounts into savings accounts as interest rates on savings accounts are greater than interest checking. During the third quarter of 2007, interest checking balances represented 30% of the average interest-bearing core deposits, compared to 35% in the third quarter of 2006.
The cost of interest-bearing core deposits was 3.36% in the third quarter of 2007, which was an increase of 3 bp from 3.33% in the third quarter of 2006 and a decrease of 6 bp from 3.42% in the second quarter of 2007. The increase in the cost of interest-bearing core deposits from the prior year was due to the mix shift from interest checking to savings as well as an increase in foreign office deposits. The decrease from the second quarter of 2007 was the result of modest decreases in consumer deposit rates. The interest on core deposits increased $17 million, or four percent, in the third quarter of 2007 over the comparable period in 2006 due to the mix shift between interest checking accounts and savings accounts and the increase of $1.6 billion in average balances. The Bancorp continues to focus on growing its core deposit balances in order to improve the funding mix and improve net interest margins.
The interest on wholesale funding decreased $63 million to $368 million, or 15%, compared to the prior year quarter primarily due to the decrease of $4.3 billion in average balances. Average short-term wholesale funding decreased $2.3 billion, or 13%, while average long-term debt decreased $2.0 billion, or 14%, in the third quarter of 2007 over the comparable period in 2006. The decline in wholesale funding balances is a result of the sale of investment securities in the fourth quarter 2006.
Provision for Loan and Lease Losses
The Bancorp provides as an expense an amount for probable loan and lease losses within the loan portfolio that is based on the factors discussed in the Critical Accounting Policies section. The provision is recorded to bring the allowance for loan and lease losses to a level deemed appropriate by management. Actual credit losses on loans and leases are charged against the allowance for loan and lease losses. The amount of loans and leases actually removed from the Condensed Consolidated Balance Sheets are referred to as charge-offs. Net charge-offs include current period charge-offs less current period recoveries. Current period recoveries relate to loans and leases charged-off in previous periods.
The provision for loan and lease losses increased to $139 million in the third quarter of 2007 compared to $87 million in the same period last year. The $52 million increase is related to loan growth during the past year, increases in delinquencies and increases in severity of loss from the decline in the real estate market. The allowance for loan and lease losses as a percentage of loans and leases increased to 1.08% at September 30, 2007 from 1.06% at June 30, 2007 and 1.04% at September 30, 2006. The increase in allowance percentage from third quarter of 2006 is primarily due to an increase in nonperforming assets and net charge-off trends from $411 million at September 30, 2006 to $706 million at September 30, 2007.
Refer to the Credit Risk Management section for further information on the provision for loan and lease losses, net charge-offs and other factors considered by the Bancorp in assessing the credit quality of the loan portfolio and the allowance for loan and lease losses.
Electronic payment processing revenue increased $35 million, or 16%, in the third quarter of 2007, compared to the same period last year as FTPS realized growth in each of its three main product lines: merchant processing, financial institutions and card issuer interchange. Merchant processing revenue increased 23%, to $122 million, compared to the same period in 2006 due to the continued addition of new national merchant customers and resulting increases in merchant sales volumes. The Bancorp recently signed large national merchant contracts with Walgreen Co., which converted during the quarter, and the U.S. Department of Treasury, which is in the process of conversion. Financial institutions revenue increased seven percent, to $78 million, as a result of continued success in attracting financial institution customers and increased debit card volumes associated with these customers. Card issuer interchange increased 15%, to $53 million, compared to the same period in 2006 due to continued growth in credit card volumes. Through the third quarter of 2007, the Bancorp processed over 19.6 billion transactions and handled electronic processing for over 2,400 financial institutions and approximately 155,000 merchant locations worldwide.
Service charges on deposits increased 13% and six percent for the three and nine months ended September 30, 2007, respectively, compared to the same period last year. The increase was driven by consumer deposit service charges, which increased 19% and 11% for the three and nine months ended September 30, 2007, respectively. Commercial deposit service charges increased five percent and one percent for the three and nine months ended September 30, 2007, respectively, compared to the same periods last year. Growth in the number of customer deposit account relationships and deposit generation continues to be a primary focus of the Bancorp.
Investment advisory revenues increased seven percent from the third quarter of 2006 primarily due to success in cross-sell initiatives within the private banking group and improved retail brokerage performance. Private banking revenue and securities and brokerage revenue increased ten percent and seven percent, respectively, in the third quarter of 2007, compared to the same period last year. Additionally, mutual fund revenue and institutional revenue increased three percent and two percent, respectively, in the third quarter of 2007, compared to the same period last year. The Bancorp continues to focus its sales efforts on improving execution in retail brokerage and retail mutual funds and on growing the institutional money management business by improving penetration and cross-selling in its large middle-market commercial customer base. The Bancorp is one of the largest money managers in the Midwest and, as of September 30, 2007, had approximately $232 billion in assets under care and managed $34 billion in assets for individuals, corporations and not-for-profit organizations.
Corporate banking revenue increased $12 million, or 15%, in the third quarter of 2007, compared to the same period last year. The growth in corporate banking revenue was largely attributable to increased institutional sales revenue, customer derivatives income and syndication fees, as well as increased letter of credit fees as the Bancorp continues to fill out its suite of commercial products. The Bancorp is committed to providing a comprehensive range of financial services to large and middle-market businesses and continues to see opportunities to expand its product offering.
Mortgage banking net revenue decreased $10 million and $18 million for the three and nine months ended September 30, 2007, respectively, compared to the same periods last year. The components of mortgage banking net revenue for the three and nine months ended September 30, 2007 and 2006 are shown in Table 5. Originations in the third quarter of 2007 were $3.0 billion compared to $2.3 billion in the third quarter of 2006; however, origination fees and gains on loan sales decreased $12 million compared to the same period last year as a result of lower margins on sales of mortgages affected by widening credit spreads in the residential mortgage market.
Mortgage net servicing revenue increased $2 million and decreased $10 million compared to the three and nine months ended September 30, 2006, respectively. Net servicing revenue is comprised of gross servicing fees and related amortization as well as valuation adjustments on mortgage servicing rights and mark-to-market adjustments on both settled and outstanding free-standing derivative financial instruments. The Bancorpâ€™s total residential mortgage loans serviced at September 30, 2007 and 2006 were $43.1 billion and $37.5 billion, respectively, with $33.1 billion and $27.8 billion, respectively, of residential mortgage loans serviced for others.
Temporary impairment on the MSR portfolio was $9 million and $3 million for the three months ended September 30, 2007 and 2006, respectively. Servicing rights are deemed impaired when a borrowerâ€™s loan rate is distinctly higher than prevailing rates. Impairment on servicing rights is reversed when the prevailing rates return to a level commensurate with the borrowerâ€™s loan rate. Further detail on the valuation of mortgage servicing rights can be found in Note 4 of the Notes to Condensed Consolidated Financial Statements. The Bancorp maintains a non-qualifying hedging strategy to manage a portion of the risk associated with changes in impairment on the MSR portfolio. The Bancorp recognized a net gain of $12 million and $6 million for the three months ended September 30, 2007 and 2006, respectively, related to changes in fair value and settlement of free-standing derivatives purchased to economically hedge the MSR portfolio. See Note 5 of the Notes to Condensed Consolidated Financial Statements for more information on the free-standing derivatives used to hedge the MSR portfolio. In addition to the derivative positions used to economically hedge the MSR portfolio, the Bancorp acquires various securities (primarily principal only strips) as a component of its non-qualifying hedging strategy. The Bancorp did not recognize any gain or loss on the sale of securities related to mortgage servicing rights during the third quarter of 2007 or 2006
Other noninterest income increased six percent in the third quarter of 2007 compared to the same period last year. This increase was primarily driven by a $15 million gain recognized from the sale of FDIC deposit insurance credits. The Bancorp was allocated these one-time assessment credits based on historical deposit levels. Other noninterest income in the third quarter of 2006 included gains totaling $10.5 million from the sale of three branches in rural Indiana and the sale of $23 million of out-of footprint credit card receivables. Income from bank-owned life insurance declined to $17 million in the third quarter of 2007 from $21 million in the second quarter 2007 due to a lower crediting rate. The Bancorp expects a similar decline in the fourth quarter of 2007 subject to continuation of current market conditions. See Note 17 of the Notes to Condensed Consolidated Financial Statements for further information.
Net securities gains totaled $13 million in the third quarter 2007 compared with $19 million in the third quarter 2006. The gains recognized during the current quarter were a result of the sale of securities from the Bancorpâ€™s available-for-sale securities portfolio.
During the third quarter of 2007, the Bancorp continued its investment in the expansion of its retail distribution network and information technology infrastructure. The efficiency ratio (noninterest expense divided by the sum of net interest income (FTE) and noninterest income) was 60.3% and 55.5% for the third quarter of 2007 and 2006, respectively. The Bancorp continues to focus on efficiency initiatives, as part of its core emphasis on operating leverage, and on expense control, although cost savings initiatives will continue to be somewhat mitigated by investments in certain high opportunity markets as evidenced by the 14 additional banking centers added during the third quarter of 2007. The Bancorp views investments in information technology and de novo expansion as its platform for future growth and increasing expense efficiency.
Total noninterest expense increased 16% and ten percent for the three and nine months ended September 30, 2007, respectively, primarily due to expense associated with the Visa/American Express anti-trust litigation settlement, investment in technology, higher de novo related expenses and increased volume-related processing expense. The eight percent increase in salaries, wages and incentives compared to the third quarter of 2006 was driven by revenue-based incentives expense. Employee benefits expense decreased ten percent compared to the third quarter of 2006. Benefits expense included $6 million of pension settlement expense in the current quarter compared with $8 million in the third quarter of 2006. Full time equivalent employees totaled 20,775 as of September 30, 2007 compared to 21,301 as of September 30, 2006.
Payment processing expense includes third-party processing expenses, network membership charges, card management fees and other bankcard processing expenses. Payment processing expense increased 25% for the three and nine months ended 2007 compared to the same periods in 2006, as a result of these primarily volume-related processing expenses. Processing volumes increased 19% and 27% for the merchant processing and financial institutions businesses, respectively, for the three months ended September 30, 2007, compared to the same quarter last year. These businesses had similar growth in processing volumes for the nine months ended September 30, 2007 over the comparable period last year. Additionally, the increase in this caption reflects the conversion of national merchant contracts during the quarter.
Net occupancy expense increased six percent and 11% for the three and nine months ended September 30, 2007 due to the addition of 36 banking centers since September 30, 2006. The Bancorp remains focused on expanding its retail franchise through de novo growth.
Total other noninterest expense increased 44% and 19% for the three and nine months ended September 30, 2007, respectively, compared to the same periods in 2006 driven by the expense associated with the Visa/American Express anti-trust litigation settlement and increased loan processing costs associated with collection activities. This increase for the nine months ended September 30, 2007 was partially offset by a decline in franchise and other taxes that resulted from a favorable settlement related to the completion of certain tax audits during the second quarter of 2007. Other noninterest expense in the third quarter of 2006 included an $11 million charge associated with the early extinguishment of debt.